SBP Working Paper Series

No. 27 October, 2008

External Debt Sustainability Analysis for

Pakistan: Outlook for the Medium Term

Sabina Khurram Jafri

STATE BANK OF PAKISTAN

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External Debt Sustainability Analysis for Pakistan:
Outlook for the Medium Term

Sabina Khurram Jafri

Analyst
Economic Analysis Department
State Bank of Pakistan
sabina.kazmi@sbp.org.pk

Acknowledgement

The author is grateful to Omar Farooq Saqib and M. Farooq Arby for their insightful
comments. The views expressed are of the author and not of the State Bank of Pakistan.

1
Abstract

This paper estimates Pakistan’s external debt by using Debt Sustainability Assessment (DSA)
technique. The main findings of the paper are that as a result of small individual shocks to
main components of external debt evolution i.e., real GDP growth, non-interest current
account balance to GDP ratio and the ratio of net non-debt creating capital inflows to GDP,
the country’s external debt to GDP ratio will increase though, but would remain within safe
limits. Secondly a significant 30-40 percent depreciation of the exchange rate has the
potential to cause the debt to GDP ratio breach the debt threshold level indentified for
Pakistan. Finally, a large combined shock to real GDP growth, non-interest current account
balance to GDP ratio, and the ratio of net non-debt creating capital inflows to GDP together
will also result in a need for another debt rescheduling.

JEL Classification: F34, H63, C02

Keywords: external debt, sustainability, Pakistan.

2
1. Introduction

Pakistan’s external debt burden, measured by external debt and liabilities to GDP ratio, after
remaining considerably higher in 1980s and 1990s has recorded significant improvement in
the past few years. A large debt re-profiling given by Paris Club creditors in FY02 along with
a general economic revival in the country materialized this improvement.1 The impact of
these positive developments, however, has been diluted by a significant expansion in
country’s current account and fiscal deficits during FY07 and FY08 due to a sharp increase in
the aggregate demand.2 To finance rising deficits the absolute level of external debt has
recorded a large US$ 9 billion increase for the last two years, again raising concerns about the
sustainability of country’s external debt stock in the medium term.

The analysis of sustainability of external debt is important given the adverse implications of a
debt overhang3 on economic growth. Some of the disastrous consequences of a debt overhang
are: limited and costlier availability of foreign financing in future, additional tax burden on
economy to pay the debt, and greater uncertainty in the economy. These factors discourage
investment and hence squeeze economic growth of the country [Monteil (2003)]. This paper
aims to evaluate external debt sustainability of Pakistan by using the standard Debt
Sustainability Assessment (DSA) approach developed by IMF and World Bank [IDA and
IMF (2004, 2007), IMF (2005) and World Bank (2005)] elaborated thoroughly in Wyplosz
(2007).

The main findings of this paper are that in response to small one-half standard deviation
individual shocks to export growth, real GDP growth and the ratio of net non-debt creating
capital flows to GDP, country’s external debt to GDP ratio although increases, but remains
within safe limits. A very large depreciation of exchange rate, however, has the potential of
causing the debt to GDP ratio to breach the debt threshold level indentified for Pakistan. In
addition, a large combined permanent shock of one standard deviation to real GDP growth,
export growth and the ratio of non-debt creating capital inflows to GDP can also result in a
need of another debt rescheduling for the country in the medium term.

                                                            
1
During this period country recorded higher GDP, LSM and export growth. In addition higher inflow of
remittances and FDI also reduced external financing needs of the country.
2
In addition, the recent external shock coming in the form of higher oil prices and poor harvests domestically
further aggravated the economic scenario leading to further worsening of the current account deficit.
3
Debt overhang refers to a situation when the face value of a country’s external debt is higher than the present
value of the debt service payments which the government is willing to make for indefinite future.

3
The paper is structured as follows: Section 2 provides analysis of Pakistan’s external debt
burden indicators with focus on recent developments. Section 3 presents review of literature
pertaining to the assessment of external debt sustainability. Section 4 outlines the model for
the analysis conducted in this paper along with the description of data. Finally, results are
discussed in section 5, and section 6 concludes the paper.

2. Analysis of Pakistan’s External Debt Indicators

Higher current account and fiscal deficits have made Pakistan traditionally dependent on
foreign borrowing (Table 1). Although higher inflow of foreign financing has contributed
partly in attaining higher GDP growth over the years, Pakistan has never been able to generate
sufficient foreign exchange earnings required to repay such huge debt burden. This is also
reflected from a long list of rescheduling that Pakistan had to arrange to be able to service its
debt obligations from time to time (Table 2).

As shown in Table 2, Pakistan achieved a generous re-profiling of US$ 12.5 billion external
debt stock owed to Paris Club creditors during FY02. While, the previous rescheduling only
focused on debt servicing payments due in a specified time, in FY02 it rescheduled the
servicing of almost the entire stock of debt owed to Paris Club creditors. This was followed
by debt write-off for a large volume of external debt that provided country enough fiscal
space to prepay its expensive debt.4

Table 1. External Debt Indicators

1980s 1990s FY00-02 FY03 FY05 FY06 FY07 FY08
Growth of External Debt% 10.3 6.5 -2.1 -2.9 1.6 3.9 7.9 14.3
Interest payment on external debt to
export earnings% 13.8 9.9 17.6 11.9 5.1 4.7 4.6 5.5
External debt/Foreign exchange
reserves (ratio) - 23.9* 22.8 3.7 3.7 2.8 2.6 4.1
Debt servicing/FEE % - - 42.1 24 11.1 10.1 9.2 9.5
Reserves/Short term debt - 10.5* 12.6 51 36.2 63.7 625.8 16.0
GDP growth 6.4 4.5 3 4.7 9 6.6 6.8 5.8
As percentage of GDP
External debt 34.6 45.6 52.5 42.1 32.9 29.5 28.2 27.7
Current account deficit 3.9 4.5 0.13 +3.8 1.6 3.9 4.8 8.4
Fiscal deficit 7.1 6.9 4.7 3.7 3.3 4.3 4.3 7.0
FEE: Foreign exchange earnings from goods, services and income and private transfers
* Average of FY94-FY99, since data for short term loans is available from FY94.

                                                            
4
Country obtained debt write-off for around US$ 1.5 billion from the US in FY03 and FY05 and prepaid a large
amount of US$ 1.17 billion owed to ADB.

4
Table 2. List of Debt Rescheduling for Pakistan Since 1971
million US$
Period Amount Rescheduled
1971-73 233.8
1973-74 107.2
1974-78 650.0
1977-78 226.3
1980-82 232.0
1985-88 11.0
1998-99 1987.6
1999-00 1241.7
2000-01 617.3
2002 12500.0
Source: Siddiqui and Siddiqui (2001, p.694) 

As a result of these measures almost all external debt indicators are witnessing an
improvement since FY02. Importantly, the external debt to GDP ratio has fallen to the level
of 28 percent in FY07, whereas debt servicing to foreign exchange earnings ratio remained at
a low of 9.2 percent during this period. The improvement in these indicators, however, does
not provide ample room for complacency. Since, country’s current account and fiscal deficits
have again started to rise in the last two years, and with this external debt growth has also
started to pickup, this has resulted in worsening of some of the external debt indicators during
FY08. Specifically, higher inflow of external (specifically short term) loans has resulted in
worsening the ratio of external debt to foreign reserves and the ratio of foreign reserves to
short term debt. Further FY08 also witnessed a slight deterioration in the debt servicing to
foreign exchange earnings ratio that was recording a continuous improvement since FY02.

3. Literature on External Debt Sustainability

The concept of external debt sustainability was defined in original HIPC initiative issued by
IMF (1997) as, “a country can be considered to achieve external debt sustainability if it is
expected to be able to meet its current and future external debt service obligations in full,
without recourse to debt relief, rescheduling of debts, or the accumulation of arrears, and
without unduly compromising growth.”

The assessment of sustainability of a country’s external debt has emerged as a complex

phenomenon due to a large number of different approaches present in the literature (Table 3).
In addition to these approaches, Debt Sustainability Analysis (DSA) in a large body of
literature [Islam and Biswas (2006), Roubini and Hemming (2004) and importantly in the
World Bank and IMF] is based on simple accounting approach by employing stress testing.

5
 Table 3. Summary of Literature Review
Study Methodology Findings

Eichengreen,B. et al. Tobit estimations Original sin (A country’s inability to borrow

(2003) internationally in its local currency) raises
vulnerability of countries to debt crisis due to ER
fluctuations

Thornton (2004) Cross section and panel regressions Institutional weaknesses and original sin
important determinants of credit worthiness

Garcia and Rigobon VAR and Motne carlo simulations to estimate Brazilian debt is affected by its market risk
(2004) risk probabilities perceptions

Hostland and Karam Stochastic simulation methods External debt sustainability is vulnerable to
(2005) volatility in exchange rate and pricing of traded
goods

Hamilton and Flavin Stationarity tests US budget balance found to be stationery

(1986)

Greiner, Koeller and Estimating a semi-parametric model with time The primary surplus to GDP ratio reacted
Semmler (2005) varying coefficients positively to higher debt ratios implying
sustainability of the public debt

Kasekende (2005) Dynamic debt model debt dynamics are
determined by four ratios - interest rate to export
growth, import growth to export growth, the
initial debt to-export and the import-to-export
ratios
Giovanni and Stochastic simulation methods
Gardner (2008)
Uganda's debt unsustainable due to higher
accumulated debt stock and higher level of
imports as compared to exports
Debt to GDP ratio is likely to fall as a result of
fiscal adjustment

Pakistan

Burney (1988) Analysis of debt burden and debt servicing Country’s debt repayment capacity in the long
indicators , and solvency situation by using run was very low during 1973-87
Critical Interest Rate (CIR) approach

Tahir (1998), Hasan Comparison of various external debt burden Pakistan was at a relatively less comfortable
(1999), and Siddiqui indicators of Pakistan with averages of Severely position as compared to most of these countries
and Siddiqui (2001) Indebted Low Income Countries, Moderately
Indebted Lower Income Countries, Heavily
Indebted poor Countries and all developing
countries from 1994-97

Chaudhary and Comparison of debt burden indicators with Country was in a relatively comfortable position
Anwar (2000) averages of India, Bangladesh, Sri Lanka, Nepal, as compared to some other South Asian countries
Maldives and Bhutan.

Chaudhary and Debt Laffer Curve approach Country’ external debt burden to be sustainable
Anwar (2001) during 1970-71 to 1994-95

The element of stress testing is the strength of this technique as against other empirical
methods discussed in the literature (Table 3). These methods provide assessment of debt
sustainability for a given level of debt, the DSA based on accounting technique provides a
broader outlook of the behavior of external debt to GDP ratio in the medium term in response
to various shocks, which is a more desirable approach for policy formulation. This paper
therefore, employs accounting technique for DSA to assess external debt sustainability in
Pakistan. The aim of this paper is to fill the gap present in the literature regarding external

6
debt sustainability analysis in Pakistan by giving more meaningful outcome for policy
formulation.

4. Theoretical Model, Data and Methodology

Debt Dynamics

The evolution of external debt is based on following identity [World Bank (2005)];

Dt = NICABt − NKFt + Dt −1 (1 + rt ) + Z t (1)

Where Dt is end period nominal debt stock in US dollars; NICABt is non-interest current

account balance, NKFt is net FDI flows, rt is average nominal interest rate on external

debt stock and Z t refers to other factors, which include exceptional financing such as debt

relief and changes in arrears, valuation adjustments, etc.;

Dividing both sides by GDP and showing lower case letters as proportions to GDP gives

(1 + rt )
d t = nicabt − nkf t + d t −1 + zt (2)5
(1 + g t )(1 + Π t )

Π t measures inflation in terms of the growth rate of the US dollar value of GDP deflator.
Equation 2 can be further decomposed to show the contribution of individual components as

⎡ rt d t −1 ⎤ ⎡ g t d t −1 ⎤ ⎡ Π t (1 + g t )d t −1 ⎤
Δd t = nicabt − nkf t + ⎢ ⎥−⎢ ⎥−⎢ ⎥ + z t (3)
⎣1 + g t + Π t + Π t g t ⎦ ⎣ 1 + g t + Π t + Π t g t ⎦ ⎣1 + g t + Π t + Π t g t ⎦

Equation (3) shows that evolution of external debt depends on the ratio of country’s non-
interest current account balance to GDP, the ratio of net non-debt creating capital inflows to
GDP, nominal interest rate on debt stock, real GDP growth, inflation and exchange rate.

                                                            
5
Since GDPt −1 = GDPt (1 + g t )(1 + Π t ) and g t is the growth rate of real GDP at time t.

7
Components of External Debt Evolution –The data

nicabt is obtained by subtracting interest payments on foreign debt from the current

account balance. A persistent increase in non-interest current account deficit indicates higher
possibility of debt distress in the future.

nkf t greater availability of FDI reduces country’s borrowing needs, because the portion of
the current account deficit financed through FDI does not add to country’s stock of external
debt.

Endogenous debt dynamics show effects of interest rate, growth, inflation and exchange rates
separately.

rt is obtained by dividing the interest payments in the current period by the previous period’s

debt stock. Its contribution to debt stock is captured by the third term in Equation (3). A rise
in interest rate increases burden of debt servicing that in turn increases country’s financing
needs.

g t contribution in the evolution of debt is shown by 4th term in Equation (3). g t indicates
country’s resource base. In Equation (3) this variable determines the behavior of
denominators and is therefore very important in determining evolution of country’s debt to
GDP ratio.

Π t and exchange rate contribution is captured by the second last term of Equation (3).
Depreciation of exchange rate is likely to increase external debt burden in terms of local
currency. Further this will also increase the value of real interest payments abroad, which
may raise the need of additional external financing [Agenor and Monteil. (1999)].

Table 4. Baseline Scenario

gt rt nicabt Πt nkft
FY09 5 2.6 -7.2 -4.2 3.1
FY10 5.2 2.6 -6.9 12.0 3.5
FY11 5.8 2.7 -6.5 11.5 3.8
FY12 6 2.7 -6.5 10.5 3.8
FY13 6.2 2.6 -6 8.0 3.7

8
Debt dynamics for Pakistan are assessed by using data on d t , nicabt , nkf t , g t , Π t and z t for

the sample period of FY 99-FY08.6

Methodology

The assessment of external debt dynamics for Pakistan is based on Equation (3). Before
estimation it is ensured that both sides of the identity match reasonably well as shown in
Figure 1. The estimation involves following steps:

To form a baseline scenario for evolution of debt to GDP ratio in medium term (Table 4).
For the construction of baseline scenario following assumptions are made:

g t is expected to remain low during FY09 and FY10. This is due to continued adverse
impact of international oil price shock and domestic energy shortages in the economy, which
is likely to increase domestic cost of production and hence might affect the manufacturing
sector growth. In addition measures aiming at reduction of aggregate demand are also likely
to affect manufacturing sector growth during these years.7 However, a number of corrective
measures are currently in place in the economy, which are likely to improve GDP growth
towards the end of projection period.8

Figure 1. External Debt Identity - Equation 3

RHS LHS
0.2
0.1
0.1
0.0
percent

-0.1
-0.1
-0.2
-0.2
-0.3
FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

                                                            
6
The data for these variables is obtained from State Bank of Pakistan (SBP). d t is obtained by taking the ratio of
country’s external debt and liabilities stock to GDP.
7
To curb aggregate demand, SBP raised discount rate and imposed Letter of Credit margin on imports in May
2008.
8
These measures include work on increasing power generation in the country, gradual removal on domestic
subsidies on oil that is likely to control fiscal deficit and thus inflation by reducing money creation in the economy.
In addition monetary tightening by SBP is likely to result in effective demand management that is also likely to
affect rate of inflation in the economy and thus will reduce cost of production.

9
nicabt is likely to fall slowly in the medium term, because of higher imports due to both rise

in international prices as well as rising domestic demand. However, as a result of demand

management policies of the SBP, trade performance is likely to improve in the projection
period resulting in a gradual fall in the non-interest current account balance to GDP ratio.

nkf t , and rt are expected to stay at their last five years average level from FY09-FY13. The

projections of Π t are made on the basis of the above mentioned path of GDP growth and the

behavior of exchange rate.9

Sensitivity analysis: The baseline path of d t is compared with the path assumed by this ratio

in various scenarios developed in this section (Table 5) by assuming shocks in debt dynamics
components. The sensitivity analysis in this section consists of two alternative scenarios and
four bound tests [IDA and IMF (2004, 2007), IMF (2005) and World Bank (2005)] with slight
modifications (Table 6).

Comparison with the Debt Threshold The debt to GDP ratios obtained in sensitivity analysis
are compared with debt thresholds defined by World banks’ Country Policy and Institutional
Assessment (CPIA) Index.10 This is in line with the improvements introduced by DSA [IMF
(2005)] made in light of the criticism received for its complete isolation from major non-
financial determinants of debt crisis. Especially, Reinhart et al (2003) and Kraay and Nehru

Table 5. Sensitivity Analysis

Alternative scenarios
Scenario 1 All key variables stay at their last ten year’s historical average levels during (FY09-FY13).
Scenario 2 Nominal interest rate on new borrowing is 2 %age points higher than the baseline during FY09 and FY10.
Bound tests
Bound 1 Real GDP growth stays one-half standard deviation* below the base line level during (FY09-FY13).
Bound 2 Net FDI stay one-half standard deviation below the base line level during (FY09-FY13).
Bound 3 Export growth stays one-half standard deviation below the base line level during (FY09-FY13).
Bound 4 Real GDP growth, non-debt creating capital flows and export growth stays one quarter standard deviation
below the base line during Fy09-FY13.
Bound 5 Real GDP growth, non-debt creating capital flows and exports growth stay one full standard deviation below
the base line during FY09-FY13.
Bound 6 30 percent depreciation in the domestic currency in FY09.
* Standard deviation is calculated by using historical data of the past ten years.

                                                            
9
Exchange rate is likely to remain at the current average of Rs 74/US dollar for the FY09 and FY10 due to the
import demand pressure and the impact of oil price shock, and afterwards it is likely to gain a little to be at Rs
73/US dollar during FY11 and further to 72 during FY12-13.
10
CPIA is a diagnostic tool that captures the quality of a country’s policies and institutional arrangements to
measures the extent to which a country’s institutions can support sustainable growth. On the basis of these CPIA
ratings debt thresholds are identified for countries. A weak, medium and strong CPIA rating corresponds to debt to
GDP threshold ratio of 30, 40 and 50 percent respectively.

10
Table 6. Stress Testing

gt rt nicabt Πt nkf t
Scenario - 1
FY09 5.2 3.2 -0.1 3.4 1.7
FY10 5.3 3.4 -0.2 3.7 1.8
FY11 5.5 3.2 -0.1 4.9 2
FY12 5.8 3.1 0.1 5.8 2.1
FY13 6.1 2.9 0.6 5.6 2.4
Scenario - 2
FY09 5 4.6 -7.2 -4.2 3.1
FY10 5.2 4.6 -6.9 12.0 3.5
FY11 5.8 2.7 -6.5 11.5 3.8
FY12 6 2.7 -6.5 10.5 3.8
FY13 6.2 2.6 -6 8.0 3.7
Bound-1
FY09 4 2.6 -7.2 -4.2 3.1
FY10 4.2 2.6 -6.9 12.0 3.5
FY11 4.8 2.7 -6.5 11.5 3.8
FY12 5 2.7 -6.5 10.5 3.8
FY13 5.2 2.6 -6 8.0 3.7
Bound-2
FY09 5 2.6 -7.2 -4.2 2.1
FY10 5.2 2.6 -6.9 12.0 2.5
FY11 5.8 2.7 -6.5 11.5 2.8
FY12 6 2.7 -6.5 10.5 2.8
FY13 6.2 2.6 -6.0 8.0 2.8
Bound-3
FY09 5 2.6 -7.5 5.3 3.1
FY10 5.2 2.6 -7.1 11.8 3.5
FY11 5.8 2.7 -6.9 12 3.8
FY12 6 2.7 -6.8 10 3.8
FY13 6.2 2.6 -6.3 9.8 3.7
Bound-4
FY09 4.5 2.6 -7.2 5.3 2.6
FY10 4.7 2.6 -6.8 11.8 2.9
FY11 5.3 2.7 -6.6 12 3.2
FY12 5.5 2.7 -6.6 10 3.3
FY13 5.7 2.6 -6.1 9.8 3.2
Bound-5
FY09 3.0 4.6 -8.5 5.3 1.2
FY10 3.2 4.6 -8.1 11.8 1.5
FY11 3.8 2.7 -7.6 12 1.8
FY12 4.0 2.7 -7.5 10 1.9
FY13 4.2 2.6 -6.9 9.8 1.8
Bound-6
FY09 5 2.6 -7.2 -13.1 3.1
FY10 5.2 2.6 -6.9 23.4 3.5
FY11 5.8 2.7 -6.5 11.5 3.8
FY12 6 2.7 -6.5 10.5 3.8

FY13 6.2 2.6 -6 8.0 3.7

11
(2004) underlined the importance of a country’s quality of policies and institutions in
determining its external debt repayment capacity.

According to the Pakistan’s average CPIA ratings of 2005, 2006 and 2007 [IDA (2007)] it
stands in the group of medium performance category that implies a debt threshold of 40
percent of GDP.11 This debt threshold as defined in IDA and IMF (2007) is for the net
present value of public and private external debt in percent of GDP.12 This paper, however,
compares the nominal value of debt to GDP ratio with these thresholds due to data limitations
involved in the calculation of NPV of external debt. 13

5. Estimation Results

The estimation results are presented in Figure 2-9 and Table 7. The baseline scenario projects
slight rise in the external debt to GDP ratio during first year of projection period compared to
the FY08 level; however this smaller increase tapers off during the last three projection years.
This pattern is due to improvement in major determinants of debt dynamics during FY10-13.
On the other hand scenario 1 projects a low and falling external debt to GDP ratio during the
whole projection period. This scenario works as a reality check to assess the degree of
optimism in the baseline scenario.14

Scenario 2 projects higher debt to GDP ratio during the initial years which implies that if
country’s total external debt stock composition changes towards more expensive loans,
country will have to increase the level of borrowing to make the annual debt servicing
payments. The projections in Bound 1 show a marginal rise in country’s debt to GDP ratio as
a result of a small permanent shock to GDP growth, keeping all other variables at their
baseline levels. Bound 2 indicates a relatively higher debt to GDP ratio in the medium term,
which reflects a pronounced impact of a one-half standard deviation shock to FDI during
FY09-FY13 as compared to the same sized shock given to real GDP growth in this period.
The path of debt to GDP ratio in Bound 3 which represents a one-half standard deviation

                                                            
11
Pakistan’s average external debt and liabilities to GDP ratio for the period FY73-FY08 is also 40.2 percent.
12
The use of NPV is to take care of the degree of concessionality of debt, since low income countries have a large
share of concessional debt in their total debt stock.
13
The calculation of NPV requires terms wise (maturity and rate) data of borrowing and debt servicing from major
lenders which includes World Bank group, IMF, ADB, IFAD, bilateral creditors, etc till the full maturity. Since
these are normally long term loans a common practice is to use 50 years projections of debt servicing. In addition
this also requires projections for expected inflows from these sources during the same period.
14
If the projected medium term debt/GDP ratio in the base line scenario is lower than that in the historical average
then this points to overoptimisim in the baseline scenario that needs to be justified with strong assumptions.

12
shock to export growth is although higher than the one obtained in bound 1, the extent of rise
in d t is smaller than that in bound 2.

Figure 2. Historical Average Scenario Figure 3. Expensive Financing Scenario

Baseline Scenario 1 Debt threshold Baseline Scenario 2 Debt threshold

45.0
43.0
40.0
40.0
dt in percent

dt in percent
35.0
37.0
30.0
34.0
25.0 31.0
20.0 28.0
15.0 25.0
FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13
Figure 4. One-half SD Permanent Shock to GDP Figure 5. One-half SD Permanent Shock to FDI
Baseline Bound 1 Debt threshold Baseline Bound 2 Debt threshold

43.0 43.0
40.0 40.0
dt in percent

dt in percent

37.0 37.0
34.0 34.0
31.0 31.0
28.0 28.0
25.0 25.0
FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13
Figure 6. One-half SD Permanent Shock to Export Growth Figure 7. One-quarter SD Permanent Shock to Export
Growth, GDP and FDI
Baseline Bound 3 Debt threshold
Baseline Bound 4 Debt threshold
43.0 43.0
40.0 40.0
dt in percent

dt in percent

37.0 37.0
34.0 34.0
31.0 31.0
28.0 28.0
25.0 25.0
FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

Figure 8. One SD Permanent Shock to Export Growth, Figure 9. One Time 30 % Depreciation of ER
GDP and FDI
Baseline Bound 5 Debt threshold Baseline Bound 6 Debt threshold
52.0
52.0
49.0
49.0
46.0
46.0
dt in percent

43.0
dt in percent

43.0
40.0 40.0
37.0 37.0
34.0 34.0
31.0 31.0
28.0 28.0
25.0 25.0
FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

13
In fact, the response of the debt to GDP ratio in bound 2 is almost the same as the debt to
GDP path obtained in Bound 4 which incorporates a combined one-quarter standard deviation
shock given to g t , nicabt and nkf t during the projection period. This fact highlights the

importance of foreign direct investment in curtailing country’s external borrowing needs.

In all of the above tests the debt to GDP ratio remained safely below the debt threshold level
as identified by Pakistan’s CPIA ratings. On the other hand, the results of the two extreme
stress tests bound 5 and 6 display probability of debt distress episode for country.15

In case of exceptionally unfavorable economic scenario represented by Bound 5 caused by a

combined one standard deviation shock given to g t , nicabt and nkf t during FY09-FY13

resulting in - real GDP growth averaging at 3.7 percent, net foreign direct investment to GDP
ratio falling below 2 percent, non-interest current account deficit to GDP ratio to be over 7
percent during FY09-FY13, and the average nominal interest rate on debt to be 2 percentage
point higher than the past five years average level for FY09 and FY10, there is a 25 percent
probability that country will not be able to continue debt servicing without obtaining another
debt rescheduling in the projection period.16

Further, a huge 30 percent depreciation of rupee against US dollar assumed in bound 6 during
FY09 is also likely to breach debt threshold level during FY09,17 however since depreciation
is assumed to be one time event so d t starts falling below the threshold level after that. The

Table 7. Stress Testing - Medium Term Path of External debt to GDP Ratio
in percent
FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13
Baseline 29.4 28.0 27.7 36.5 35.9 34.9 34.4 34.3
Scenario 1 29.4 28.0 27.7 31.2 28.1 25.1 21.9 19.5
Scenario 2 29.4 28.0 27.7 37.1 37.0 35.9 31.8 29.4
Bound 1 29.4 28.0 27.7 36.8 36.4 35.7 35.4 35.5
Bound 2 29.4 28.0 27.7 37.5 37.7 37.4 37.6 38.1
Bound 3 29.4 28.0 27.7 36.8 36.4 35.7 35.5 35.6
Bound 4 29.4 28.0 27.7 37.1 37.0 36.6 36.6 37.0
Bound 5 29.4 28.0 27.7 40.9 44.2 45.9 47.8 49.8
Bound 6 29.4 28.0 27.7 40.2 35.3 33.4 31.9 30.9
Debt threshold 40 40 40 40 40 40 40 40

                                                            
15
According to Wyplosz (2007) these thresholds for debt based on CPIA ratings, are chosen in a way that when
the debt to GDP ratio reaches that level there is a 25 percent probability of debt distress.
16
This stress test is also repeated by keeping the nominal average interest rate at the five years average level
during FY09-13. The results show that the debt threshold is breached even in this case in the period FY11-FY13.
17
d t reaches 42.6 percent in FY09 as a result of a 40 percent depreciation in exchange rate. However, this ratio
falls below the threshold level in the following year.

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rise in d t during FY09 might be attributable to increase in the real value of interest payments

abroad that may raise the need of additional external financing [Agenor and Monteil. (1999)].

6. Conclusion

The results of DSA conducted in this paper show that the debt to GDP ratio remains
significantly below the debt threshold level after small individual shocks to the determinants
of debt evolution during FY09-FY13. In case of the worst case scenario of combined shocks,
however, the extent of increase in the debt to GDP ratio is higher, which even breaches the
debt threshold level if the size of the shock is increased. Further a very large depreciation of
the exchange rate alone has the potential of starting a debt distress episode for the country.
Another important finding is that the fall in the foreign direct investment can also lead to a
large increase in country’s debt to GDP ratio in the medium term.

These findings suggest that to keep country’s external debt stock within sustainable limits
there is a need to focus on the areas of foreign direct investment and exchange rate. During
FY08 these two areas have been a source of concern. The level of FDI inflows witnessed a
large increase during FY01-FY07, due to improvement in economic fundamentals and
investment climate in the country. However, the political uncertainty in the country coupled
with deterioration in the major macroeconomic indicators caused discontinuation of this
pattern during FY08.

Moreover the huge increase in the trade deficit during FY08 also led to a substantial
depreciation of exchange rate during FY08. The fall in the value of rupee against the US
dollar witnessed a small reversal after the corrective measures taken by the SBP. For the
medium term correction of this trend, there is a need to control widening of the current
account deficit through effective demand management policies to curtail the unabated rise in
imports. In addition, improvement in the performance of major export sectors is also required
to keep current account deficit within manageable limits. Especially as seen above a fall in the
export growth has a potential to cause increase in the country’s external debt to GDP ratio in
the medium term. The correction of external imbalance will help ease pressure on the
exchange rate of rupee versus US dollar and will also reduce probability of any significant
increase in the debt to GDP ratio.

These findings have great relevance with the present macroeconomic environment of the
country. The current movement of the major macroeconomic indicators - e.g., real GDP

15
growth rate, non-interest current account deficit to GDP ratio, exchange rate and the ratio of
non-debt creating capital flows to GDP - is depicting a scenario of a combined shock, though,
of a smaller intensity. There is a need to control this trend in the medium term to keep the
external debt to GDP ratio within safe limits. The resort to demand management policies by
the SBP is a step in the right direction, but there is a need to supplement the impact of these
policies by achieving more fiscal discipline. If this trend is not corrected the debt dynamics
are likely to explode and the debt to GDP ratio is likely to cross the debt threshold in the
medium term.

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